Protecting Investors: Hedge Fund Governance and Transparency

Protecting investors in hedge fund accounts

If you’ve been keeping up with the news, you’ve probably noticed that various hedge funds, particularly SAC Capital, have been in the headlines for questionable behavior. This raises some very serious questions about the quality of hedge fund governance and the level of transparency currently required from funds.

A recent study, written by New York Law School Associate Professor Houman Shadab, analyzes historical hedge fund governance and offers suggestions for how governance can be improved upon.

What are hedge funds?

So, you may be asking yourself, what exactly is a hedge fund? For our purposes, a hedge fund is a “private investment vehicle that is not subject to the full range of restrictions on investment activities, disclosure obligations, and other regulations imposed by federal law on investment companies.” These funds are run by account managers, who are compensated through a fee based on annual profits and performance.

The primary components of hedge fund governance consist of the following:

Investors that are cautious and quite willing to exercise their short-term redemption rights

Fund managers that are very sensitive to the correlation between their pay and performance. This is because funds are compensated through an annual management fee (about 2%), a performance fee (usually 20%), as well as their own investment in the funds they manage

Investor demand for quality governance and oversight

Monitoring from creditors and derivatives counterparties

Shadab argues that, “hedge fund governance is a form of managerialism because the funds’ underlying legal regime gives managers near complete authority over the structure and operations of the funds they manage.” Managerialism, as defined in the article, is the control of a business enterprise by a manager, while shareholders and directors play a more passive role. However, hedge fund managers still have to appease their investors (limited partners).

Aren’t hedge funds a rip-off?

Shadab claims, “that hedge fund managers are not systematically ripping off investors. This is because empirical studies do not find that fraud or other types of agency costs are pervasive and significant.” His argument is that the market for hedge fund managers seems relatively competitive and well priced.

As can be expected, there are a lot of people who disagree with this sentiment. For example, Edward Siedle compared hedge fund management to theft when we wrote, “I call hedge funds ‘money management on steroids’ because these funds charge fees hundreds of times greater than traditional investments… My friends, if you’re going to steal $1 million, this is the way to do it.”

Shadab seems to disagree with this sentiment on a philosophical level. While critics of hedge funds believe fees are unpredictable (even though they are clearly laid out in a fund’s documents), his argument maintains that governance does just enough to ensure everyone is protected: investors, managers, and directors.

So, what’s wrong with hedge funds?

Shadab certainly doesn’t believe that hedge funds are perfect, though. For example, he believes that, “hedge fund boards do not provide the same level of oversight and responsiveness as do boards in public corporations.” This is primarily due to the fact that hedge funds are not required to have a board, though research suggests investors in funds without a board would welcome the change.

Shadab makes several other suggestions for improvement. For one, it has also been reported that investors prefer hedge fund directors to limit the number of boards they sit on so their attention is not too distracted. He is also very clear that governance around fraud could be improved.

While there is clearly room for improvement, Shadab cites fund performance studies that show investors still come out on top. He writes: “…a recent study found that nearly three-quarters of fund profits go to investors, not managers, which indicates that performance fees are not generally too high or structured to allow managers to be paid before losses are passed along to investors.”